Short the Shekel?
Four reasons to resist "something for nothing".
Jonathan Lipow 1 Feb 07 13:12
The Bank of Israel’s recent reduction of interest rates to 4.25% raises a question: would this be a good time to short the shekel and bet on the US dollar? The answer is "no".
The case for shorting the shekel is based on the difference between nominal interest rates in the US and Israel. With the dollar rate at 5.5%, investors could supposedly earn themselves a tidy profit by borrowing cheaply, in shekels, and investing in short term dollar instruments. As an added enhancement, if such “carry trades” caught on, the shekel would devalue offering those bold enough to act now additional profits.
Such a trade sounds appealing and even seductive. Who can resist “something for nothing?” Well, try to resist, because there are four problems with the trade outlined above.
Firstly, who said that interest rates were actually higher in the US than they are in Israel? Real interest rates, best measured by comparing the yields on inflation-linked government bonds, are substantially higher in Israel than they are in the US. This makes it attractive to bet on the shekel rather than the dollar.
Secondly, it generally makes sense to short currencies that are over-valued based on fundamental “purchasing power parity” metrics. Yet there is no sign that the shekel is overvalued. While a case could have been made for shekel overvaluation as recently as 2000, the substantially lower inflation rate experienced by Israel relative to more normal countries in the interregnum has largely dealt with the problem. Today, the shekel is reasonably valued.
Thirdly, it makes sense to short the currencies of countries experiencing severe balance of payments problems. Israel, of course, is as far from facing a balance of payments crisis as is possible. The country is a large net creditor and runs huge current account surpluses. Further, a good portion of Israel’s foreign assets are held by the Bank of Israel as completely liquid currency reserves.
Finally, variations in central bank policy, as well as variations in the personalities of central bankers, should play a central role in the calculus of any “would be” currency trader. So let us consider the differences between the US Federal Reserve and the Bank of Israel.
The Fed is run by Ben Bernanke. While no “inflation dove,” Bernanke clearly tries to strike a balance between price stability and other “minor” considerations such as unemployment and economic growth. The Bank of Israel, however, is run by Stanley Fischer, widely regarded as one of the world’s most doctrinaire proponents of price stability.
Now, we cannot know what challenges face the world economy in the future. It is a safe bet, however, that some financial crisis will roil international markets sometime soon. The reason is simple such crises are like earthquakes. While they cannot be predicted, they simply must take place from time to time.
When faced with a crisis, it is likely that Bernanke will choose the course of action likely to be best for the US economy. Certainly, he would not hesitate to allow the dollar to devalue, or even for inflation to breach his by- now famous “2% comfort zone”, if objective economic conditions justified such a decision.
Stanley Fischer, however, is likely to choose the course of action best for the preservation of price stability. Indeed, as he most recently demonstrated during the Lebanon conflict, his instincts lead him to raise interest rates under crisis conditions. That, combined with the other factors mentioned above high real interest rates and a strong balance of payments position makes the shekel an attractive long rather than short relative to the dollar.
The practical implications are obvious: it’s still a great idea to diversify the portfolio in dollar investments, but a simple hedge to the shekel specifically to those measured in it can be a good idea.
Dr. Jonathan Lipow is the chief economist of Forum FIE, the Israeli distributor of Vanguard and Wellington portfolio management products in Israel. In addition, Dr. Lipow manages the Forum International Equity Fund, a global hedge fund.
Published by Globes [online], Israel business news - www.globes.co.il - on February 1, 2007
http://www.globes.co.il/serveen/globes/DocView.asp?did=1000178688&fid=980
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